WORKING CAPITAL FINANCING

Accrued Expenses and Income in Advance

Accrued Expenses
Accrued Wages and Salaries.
2. Accrued taxes and Interest.
1.

Accruals vary with the level of activity of the firm.

Generally not controllable by management.

Income in Advance
1.

Advance Payments received.

Trade Credit
Trade credit represents the credit extended by the

suppliers of goods and services in the normal course of

business.
An informal arrangement, granted on an open account
basis, not formally acknowledged as a debt.
May also take the form of bills payable.
Spontaneous source of finance.i.e. obtained in normal
course of business, no formal negotiation.
Confidence of suppliers key to securing trade credit.

Pros and Cons of Trade credit

Advantages
Easy Availability.
2. Flexibility.
3. Informality (No Restrictions).
1.

Disadvantages
1.

Implicit Cost in case cash discount is offered by

supplier.The cost of trade credit is:
Discount %
360

100 Discount % Credit period Discount period

2.

Stretching A/P can prove to be very costly.

Example:

The credit terms are 2/15, net 45. What is the cost
of trade credit?

Commercial Paper
Unsecured

negotiable promissory notes issued at a

discount by from face value firms to raise short-term
funds.

The

effective pre-tax cost of commercial paper or implied

yield is:
FaceValue Sale Price
Implied Yield

Sale
Price

Sales

price is net amount realised

360

Days
of
Maturity

Example:
1.

A firm sells 120-day commercial paper (Rs 100 face

value for Rs 96 net, determine the interest yield.

2.

A company issues a 90-day CP of a face value of Rs

1000 at Rs 985. The credit rating expenses are 0.5 per
cent of the size of issue, IPA(Issue and Paying)
charges being 0.35 percent and stamp duty 0.5
percent. What is the cost of CP?

Features of Commercial Paper

1.

Issuer requirements:
Tangible Net worth Rs.4 cr
Sanctioned working capital limit from a bank/FI
and the borrowal account is a standard asset

2.

Maturity -7 days 1 yr

3.

Rating-Issued by firms which enjoy a fairly high

credit rating, P-2 of CRISIL.

4.

Denomination : Rs. 5 lakhs and multiples thereof

Merits and Demerits of Commercial Paper

Merits
1.
2.
3.
4.

Alternative Source of Finance for well rated cos.

High Liquidity in Money Market.
Relatively Low Cost of C.P.
Flexibility
Maturities tailored to match issuers cashflows

Demerits
1. Only available to financially sound companies.
2. Can not be redeemed until maturity.
3. Limited to the amount of excess liquidity of purchasers.

Inter-corporate Deposits
A deposit made by one company with another, normally for a
period up to six months
Typically unsecured and arranged by financier.
Interest rate depends on amount and time period
Limits:50% of the Net Owned Funds
Minimum tenor of borrowing: 7 days.
Usually of three types:
Call deposits,
three-month deposits, and
six-month deposits.

Bank Finance for Working Capital

Overdraft
Cash

Credit
Purchase or Discounting of Bills
Letter of Credit
Working Capital Loan

Security for Bank Finance

Hypothecation
Pledge

Regulation of Bank Finance

Dehejia

Committee (1968)
Tandon Committee (1974)
Chore Committee (1979)
In the deregulated economic environment in
India recently, banks have considerably
relaxed their criteria of lending. In fact,
each bank can develop its own criteria for
the working capital finance.

Dehejia CommitteeExisting Deficiencies

Difficulty

in credit planning by lender- amount of

credit is borrower decision

The

bank credit treated 1st source of finance instead

of supplementary source

Credit

amount based on security available, not

borrowers level of operations

Efficient

follow-up of the industrial operations of the

borrower ensures safety of bank funds not security.

The Tandon Committee Recommendations

1.
2.
3.
4.

Norms for current assets

Maximum permissible Bank Finance (MPBF)
Emphasis on Loan System
Periodic Information and Reporting System:

The Tandon Committee Recommendations

Periodic Information and Reporting System:
1.

Quarterly infor. System-Form I1.

2.

2.

Quarterly infor. System-Form II1.

2.

3.
4.

Production and sales estimates for the current year and the subseq.
qtr
Estimates of assets and liabilities for subseq. Qtr
Actual production and sales- completed and current year
Actual current assets and liab. for completed qtr.

Half yearly operating statements- Form III: actual

operating performance for half-yr ended and its estimates
Half yearly operating statements- Form IIIB: actual
sources and uses for half-yr ended and its estimates

The Chore Committee Recommendations

Reduced

Dependence on Bank Credit.

Credit

limit to be separated into peak level and

normal peak level limits.

Existing

Lending System to Continue.

Information

System.

Maximum Permissible Bank Finance

(MPBF)
Tandon Committee had suggested three methods for
determining the MPBF
Method 1 : MPBF = 0.75 (CA CL)
Method 2 : MPBF = 0.75 (CA) CL
Method 3 : MPBF = 0.75 (CA CCA) CL
CA = current assets
CL = non-banking current liabilities
CCA = core current assets

Example:

The following are the details of current assets and current

liabilities of ABC Ltd. find out the MPBF as per the 3
methods suggested by the Tandon Committee.

Current assets

Rs in lacs Currrent Liabilities

Rs in lacs

Raw material

200

Creditors

250

Work- in-progress

100

Other current liabilities 50

Finished goods

200

Bank borrowing

Receivables

300

300

Other current assets 50

Total

850

600

Present Practice

Assessment of working capital requirements:

Projected balance sheet method

Cash budget method
Turnover method

(earlier Nayak committee recommended loan of 20% of turnover for borrowers

with WC limits <100 lacs.

Current ratio Norm:

1.33:1 benchmark. Lower accepted dependent on circumstances.

Emphasis on loan system

Financial follow-up reports

FFR I and FFR II- similar to form II and Form III respectively

PUBLIC DEPOSITS
These are unsecured deposits from the public.
Public deposits cannot exceed 25 percent of share
capital and free reserves.
The maximum maturity period allowed for public
deposits is 3 years. However, for NBFCs it is 5 years.

Rights Debentures or short term

unsecured debentures
A company can issue rights debentures to its shareholders
to augment the long-term source for working capital
requirements
The key guidelines applicable to rights debentures relate
to the quantum of such issues and the debt : equity ratio
(<1:1)
Alternatively issue unsecured debentures for periods<18
months. No credit rating required. Only established firms can
issue these and in non-sluggish periods

Factoring

Factoring involves provision of specialised services relating to

credit investigation,
sales ledger management,
purchase and collection of debts,
credit protection
provisions of finance against receivables and
risk bearing.
In factoring, accounts receivables are generally sold to a financial
institution that charges commission and bears the credit risks
associated with it.

FACTORING
1
Places order
3
Delivers goods and
invoice with notice
to pay the factor

CLIENT
(SELLER)

4
Sends
invoice
copy
2
Fixes
limit

8
Pays
balance
amount

CUSTOMER
(BUYER)

6
Follows
up

7
Pays

5
Prepays
up to
80%
FACTOR

Benefits of Factoring
(i) The firm can convert accounts receivables into cash without
bothering about repayment.
(ii) A definite pattern of cash inflows.
(iii) Eliminates the need for credit department- Continuous
factoring virtually
(iv) Unlike an unsecured loan, compensating balances are not
required in this case.
Another advantage consists of relieving the borrowing firm of
substantial credit and collection costs and to a degree from a
considerable part of cash management.